Weidmann reawakens debate on Bundesbank’s power

Commentary: Germany’s reputation still carries clout

LONDON (MarketWatch) — “How many divisions has the pope?” asked Karl Otto Pöhl, the legendary Bundesbank president during the 1980s, pondering the power (or lack of it) of the German central bank over political and economic events. Pöhl pointed out that the Bundesbank’s clout in German (and European) politics and society depended solely on its ability to maintain a premier position in public opinion.

Three decades later, Jens Weidmann, Pöhl’s five-times-removed successor, has sent a letter to European Central Bank President Mario Draghi that raises the same fundamental questions, but in a much more dramatic form than even Pöhl envisaged.

Pöhl emphasized that, without the combined might of German financial networks and the media, the Bundesbank’s formal independence granted through its governing statutes signified nothing. Pöhl’s reference to the ironical statement from Josef Stalin reacting to criticism from the pontiff over the Soviet Union’s persecution of Catholics underlined that, deprived of armies or arsenals, the Bundesbank itself had no real power, but could wield influence through the forcefulness of its own reputation.

That was also the message in the Weidmann letter, leaked last Wednesday night just hours after the ECB announced a second €530 billion portion of three-year cheap loans to 800 banks. Weidmann highlighted the Bundesbank’s concern about the latest loosening of the ECB’s collateral requirements on bank lending within economic and monetary union (EMU).

Most significantly for German public opinion, Weidmann’s message spoke about possible losses for the Eurosystem of member-country central banks caused by growing internal imbalances among European central banks generated by capital flight from southern EMU members. Weidmann’s letter, which found its way into the columns of the conservative Frankfurter Allgemeine Zeitung newspaper, appeared to suggest more secure collateralization for the overall ECB credits to weaker EMU central banks, which now amount to more than €800 billion under the ECB’s Target-2 electronic payment system.

The latest Bundesbank figures show that the Bundesbank’s share of these credits rose from €498 billion to €547 billion in February, pointing to continued capital flight from the southern to the northern members of EMU.

Weidmann’s worries stand in contrast to the relative equanimity shown by Chancellor Angela Merkel about the ECB’s operations. At the European Union’s latest summit in Brussels at the end of last week, she praised the ECB’s action in pumping €1 trillion in liquidity into the euro banking system in the past three months. It was an “important step,” she declared, which would buy time of “two to three years” not simply for the banks to recapitalize, but also for governments to curb their borrowing and launch new economic programs.

Weidmann has no direct means to change the ECB’s monetary policy arrangements. He has just one vote of out of 23 on the ECB Council, where the majority of votes are held by debtor countries. However, just as Pöhl’s comments about Stalin emphasized, through public opinion, the Bundesbank can hold its own in the growing debate about the risks on the balance sheet of the ECB and the Eurosystem. It is a debate that the Bundesbank is stirring at its own peril, because these risks would trigger losses for the individual central banks and the fiscal authorities behind them only in the event that EMU started to fragment — a possibility that Weidmann is presumably envisaging, for otherwise he would not have made his views public.

In the letter leaked to the FAZ, Weidmann speaks of possible “loss of reputation” for the ECB and its constituent banks, and proposes more openness about the risks that are growing internally in EMU not subject to any form of political or parliamentary control. Under new ECB liquidity rules, national central banks in peripheral countries are supposed to bear themselves the risks of looser collateral policies for lending to banks within their jurisdictions. However, if the euro broke up, national central banks in peripheral economies might not be willing or able to refund the rest of the Eurosystem for any losses. The central banks in Northern Europe might then be exposed to losses that could be made good only by taxpayers in their own countries.

The official Bundesbank line on the growing Target-2 imbalances is that “there is a problem only if there is a problem,” i.e., losses are crystallized only if EMU comes at least partially to an end. An article in the Bundesbank’s monthly Bulletin for March 2011 sums up the position: “There is no immediate change in the level of risk to the Bundesbank ... Although the Eurosystem as a whole has indeed incurred additional financial risks ... an actual loss will be incurred only if and when Eurosystem counterparty defaults and the collateral it posted does not realize the full value of the collateralized refinancing operations despite the risk control measures applied by the Eurosystem. Any actual loss would always be borne by the Eurosystem as a whole, regardless of which national bank records it.”

The latest spat over collateral and possible losses follows a further downgrading of Greece’s credit rating after its second bailout, agreed by the European Union only after repeated delays and much wrangling. The ECB said it can no longer accept the collateral of Greek government securities for use in its lending operations. It has circumvented this point by declaring that such lending backed by national central banks could provide liquidity using so-called “emergency liquidity assistance” until a new €35 billion collateral enhancement scheme is activated, at which point Greek bonds would again be eligible, in principle.

In anticipation of downgrades following the Greek bailout, euro-area governments and the ECB had agreed that Greece would receive €35 billion worth of support from the EFSF, the euro rescue fund, which it would pass to the ECB as a contingency payment so that the central bank could keep accepting Greek bonds and other assets underwritten by Athens in its lending operations. However, this support measure has not yet been activated, but is expected to be in place by mid-March 2012, an awkward gap that the ECB is now stepping in to bridge.

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